Is there value in Europe’s equity markets?

European equities have been in fashion this year, but their popularity may be waning as valuations become less attractive and signs emerge that economic growth may have peaked. We caught up with Julian Chillingworth, CIO at Rathbones to discuss whether there is value in Europes equity markets or if the outlook for the region looking more uncertain?

Inflows have been particularly strong since the market-friendly Emmanuel Macron was elected France’s president, giving financial markets another reason to celebrate. Although the Macron trade has cooled and the President’s popularity has fallen, capital is still flowing into European equities. Some €20 billion had poured into the asset class in the year to late June, significantly more than the €16 billion that investors had put into US equities. Notably, eurozone equities only re-entered positive territory at the end of June after outflows suffered in 2016, so there could still be some momentum in this trade.

Actively seeking value

The question for active managers, seeking to outperform the broader market, is where to find value in European equities? At the end of the first quarter, European companies beat earnings forecasts by posting their best results in a decade; second-quarter earnings were more tempered.

The short-term leading indicators that we monitor suggest economic growth in Europe peaked in the second quarter. The IFO survey suggests the growth rate remain flat for the rest of the year. Meanwhile, data from purchasing managers indices (PMIs) of business activity have been more negative, suggesting a slight deceleration. Our preferred indicator is the Belgium business confidence survey because it includes only a few intercontinental exporters and so gives a clearer gauge of domestic dynamics — the latest reading echoes the PMI data by suggesting the pace of growth is slowing (figure 4).

Monetary dynamics have also become less supportive: inflation-adjusted growth of money supply has slowed, and private sector borrowing has weakened sharply (figure 5). New lending to firms is still very weak outside of Germany and France, and there’s still a lot of bad debt hanging over from the previous decade’s excesses.

Inflation may also weaken further if the euro stays strong. There’s more slack in eurozone labour markets than in other developed economies, and wage pressures should remain subdued. So if inflation is likely to remain low, leverage is still high and growth is decelerating, the European Central Bank is unlikely to be increasing interest rates in the foreseeable future, which might mean bond yields are peaking.

This has implications for asset allocation because for the past 10 years or more Europe has only outperformed global equities when German Bund yields were rising. At the same time this does mean little risk of a negative surprise from rising rates.

Is debt a concern?

Europe only tends to outperform global peers when value stocks (more cheaply valued equities) outperform, and ‘value’ is stuffed full of financials at present. They are one of the few areas where valuations look inexpensive, yet they will struggle to grow earnings in an environment where interest rates are extremely low and not expected to rise for the foreseeable future.

Financials account for 22% of Europe’s stock market, and banks comprise roughly half of this weighting. Financials are not only the largest in the index, they are also pivotal for the outlook for many underlying economies. Many eurozone markets are extremely sensitive to the performance of banks, even more sensitive than the weight of banks in the index would imply. What this means for investors is that if something were to happen to derail banking sector performance, it would affect the wider economy.

Financials and consumer discretionary shares are expected to account for more than a third of European earnings growth over the next 12 months, according to consensus estimates from analysts. Essentially, to have a positive view on Europe requires a positive view on these sectors.

Banks’ net interest incomes have recovered this year but non-interest income has not — if bond yields have peaked, bank income may roll over too. Non-performing loans — which clog up bank balance sheets, drag down return on capital and restrict the capacity to extend new loans — have declined everywhere bar Italy, where 15% of all loans are delinquent, and, to a lesser extent, France. However, provisions made against expected losses on delinquent loans are still eating into banks’ operating income. In Italy, provisions being set aside for loan losses still equal 50% of pre-provision operating income; in Germany and Spain they account for 40%. In short, bad loans are still severely compromising business models.

Our view

In our view, European bank stocks should be even cheaper than they are at the moment. The consumer discretionary sector is relatively inexpensive, trading on 15.7 times forecasted earnings.

One concern we have for consumer stocks is that leading brands will not carry the weight they did in the world before Amazon. The potential for Amazon to eat into the market share of established companies is immense and yet to be tested in Europe.

Financial markets are likely to experience some volatility ahead of Italy’s elections, which are due to be held before next April. The anti-establishment 5Star Movement is losing ground, but even if the party were to get into government, polls show Italians largely support the euro, ECB and other EU institutions. So in any referendum on euro membership held in the next 12 months, the country is unlikely to vote against the status quo.

To conclude, we find it difficult to be positive on European equities without an acceleration in global growth, rising bond yields and an improving outlook for the financials and consumer discretionary sectors.

What looks like value in European equities may not be such a great buy after all, when you consider the growth prospects.

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